Here's an excerpt from the National Venture Capital Association, talking about compensation and economic growth.  Can you guess what [x] is? 

Without a doubt, [x] [is] an important part of a successful formula.  Venture-backed companies, steeped in the culture of shared ownership, have had an enormous impact on the American economy. ... In the current shower of negative press over the excesses of a few, it is important to keep our eye on the real economic prize and the role that [x] [has] played in maintaining economic growth.

As we can see from the troubles in many economies, here and abroad, growth in jobs and GDP cannot be taken for granted.  ... Just as [x] [has] been an essential part of the engine that has driven America's entrepreneurial leadership and economic growth over the last decade, [it] can be a key to a brighter future for many more.  ...

But the U.S. does not have a monopoly on [x].  We see an example of the need to be prudent in the technology area, which has serious competitors outside the U.S.  Taiwan, for example, has built great technology companies on the foundation of [x].  ... These strong Taiwanese companies have been built with American engineers and managers who joined them in part because of more favorable [x] treatment in Taiwan.  The Peoples Republic of China is also beginning to build a technology industry with the help of [x].  Several European nations are revising their accounting rules to encourage the use of [x].  The world has taken notice of our economic success and has discovered the importance of [x] as a competitive tool.

So .. can you guess what [x] is?  Hint:  It's not carried interest.

It's stock options.  The NVCA lobbied heavily against the proposal to record stock options as an expense on the income statement, arguing that the accounting change would substantially harm the technology industry.  The accounting change was eventually made a couple of years ago, and yet the sky has not fallen, and Silicon Valley has not moved to Taiwan. 

The same goes for carried interest.  Changing the tax treatment of carried interest will not cause the sky to fall, I promise. 

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I'm heading down to DC in the morning for a debate on carried interest hosted by the American Enterprise Institute.   The event is at 2 pm; details here. 

The carried interest buzz today was about the National Venture Capital Association breaking ranks with the private equity industry by suggesting that legislation, if enacted, should carve a distinction between the buyout industry and the venture industry.  It was suggested that this could be accomplished by retaining the status quo for funds that invest in new companies.  But even if that were a good idea--and I remain unconvinced that VCs need a tax subsidy--I don't understand how it would work mechanically. 

For example, when a buyout fund buys a division of an existing public company, those assets go into a new corporation managed by the fund.  Does that count as a new corporation?  Or an old one?  What about start-ups that struggle along with angel financing for a few years and then get venture financing.  Newco or Oldco?  Limiting the capital gains preference to companies held for more than 4 years excludes "buy it and flip it" deals, but also creates a greater lock-in effect.  I'm struggling to think of a way to distinguish between venture-funded portfolio companies and buyout-funded portfolio companies that would work.  One possibility, I suppose, is to revitalize section 1202, which reduces the capital gains rate for investments in small business corporations, measured by the size of the assets of the firm at the time of the investment.  This could be added into the Levin bill as an exception to the rule stating that investment partnership services income is treated as ordinary income. 

The best tax policy for encouraging entrepreneurship is to have a broad tax base with low rates.  The carried interest bill broadens the base and might stave off a hike in the top marginal rates.  Even assuming we want to use the tax code to encourage entrepreneurship, carving out venture capital from the Levin bill isn't the way to go about it. 

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Politico reports on the hottest tax issue in DC:  How much revenue would be raised by the carried interest bill -- or, as the tax nerds say, how will the Joint Committee score it? 

The Joint Committee on Taxation has responsibility for scoring tax bills, and they've been mum for some time.  That's understandable.  It's a difficult proposal to estimate, as one has to make and justify a lot of assumptions about how the industry works and how it might adapt to the new rules. 

The word on the street, from a couple of different sources in DC, is that the proposal will score "way higher" than the current estimates, including both Professor Knoll's $2-3 billion estimate or my own back of the envelope $4-6 billion annual estimate.  (The Politico story refers to Knoll as an "academic deity", which is even better than an "intellectual godfather."  Something to aspire to.)

One reason for the higher score is that we just looked at private equity, while the Levin bill would reach real estate, venture capital, and certain hedge funds as well.  The Levin bill would also raise a lot of revenue from the Medicare tax, which, by treating carry as ordinary income, subjects those wages to a 2.9% tax (uncapped, unlike social security).  Add it all up and I wouldn't be shocked by a score over $10 Billion annually.    Not enough to repeal the AMT by itself, but enough to make a dent.  Or maybe a dimple.

I should note that my sources are non-governmental, so who the heck knows what the Joint Committee -- the only source that matters -- is actually thinking.   Maybe someone will set up a prediction market.

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I'm in DC for tomorrow's Ways & Means Hearing on Fair and Equitable Tax Policy for America's Working Families.  In preparing for the hearing, I was reading the Joint Committee on Taxation's report on carried interest, which cites the Glom. (!)  See footnote 112. 

In the meantime, I've just posted a new paper on SSRN, Taxing Blackstone.  Here's the abstract:

This Essay analyzes the "Blackstone Bill," which would treat Blackstone and other publicly-traded private equity firms as corporations for tax purposes.  Earlier this year, the Blackstone IPO fueled a heated, somewhat confusing debate about taxing private equity.  This Essay seeks to clarify what the legislation will accomplish, and what it won't.

There are two ways of looking at the Blackstone Bill.  The first way is as a substantive change in the tax law.  Specifically, the bill may be viewed as a rifleshot approach to changing the tax treatment of carried interest.  The second way is to think of the bill as a mechanical correction of the publicly-traded partnership rules.  Specifically, the bill may be viewed as a technocratic response to the regulatory gamesmanship of Blackstone's deal structure, which allows it to avoid the corporate tax that other, similarly-situated financial intermediaries pay.

In terms of a change in the substantive tax treatment of carried interest, the merits of the Blackstone Bill are questionable.  The efficiency and distributive consequences are unclear; the revenue potential is indeterminate.  The bill fails to achieve what we ultimately want: taxing the returns from managing financial assets consistently regardless of the form in which the business is conducted.

But the Blackstone Bill is nonetheless defensible as a response to aggressive regulatory gamesmanship.  To put it more provocatively, the bill is justifiable because the Blackstone IPO structure is offensive to the rule of law values on which our tax system relies.

You can download the paper here, or email me.

Or, if you prefer the snazzy visuals (click on the images for a less-blurry view):

This paper was a tough one to write.  The normative case for taxing Blackstone as a corporation is weaker than I thought when I started the paper; the weakness relates directly to the shaky case for having a corporate tax at all.  And yet there is something to be said for enforcing rules, flawed as they may be.  I would prefer that Congress reform the taxation of carried interest and, so long as I'm at the wishing well, I would wish for reform of Subchapter M and integration of corporate and shareholder-level taxes.  But taking the corporate tax and current tax treatment of carried interest as a given (at least in the short run), I do think the Blackstone Bill is worth passing. 

I welcome your comments and suggestions by email. 

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Lynnely Browning profiles Lee Sheppard in the Int'l Herald Tribune.  I don't always agree with Lee, but she does a wonderful job of asking the hard questions and keeping us all current.  And give her credit -- a couple of years ago when the Treasury proposed partnership tax regulations which would quasi-codify the status quo on carried interest, Lee was the only one out there making a fuss. 

And what would we do without her cultural commentary on what the fashionable set in the Hamptons is wearing these days?

Speaking of the Hamptons, the rioting over carried interest has begun.

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Michael Knoll has a cool new paper estimating the revenue effects of changing the tax treatment of carried interest.  Depending on various assumptions, he comes up with about $3 Billion a year (see paper at p. 12; if character is changed to ordinary income, then additional tax collected would amount to between 2.4 and 3.4 billion).  I'd previously done a very rough back of the envelope calculation to come up with $4-6 billion a year. 

Among Knoll's key assumptions:

1) $200 Billion a year invested in private equity. Is this too low?  This is a high estimate by historical standards, but low given recent trends.  On the other hand, the recent credit market shakeup may slow fundraising for a while. 

2)  Scope of the change.  Knoll only looks at private equity, but at a minimum the change would also apply to hedge funds.  Hedge funds that make long-term investments might also be affected.  It's also possible that real estate, timber, and oil and gas partnerships might also be affected, depending on how the politics play out in DC.

3)  Volatility.  Knoll uses a Black-Scholes model to value the carry and estimates volatility of the average fund at 20%.  No idea if this is right - average volatility for a portfolio company would be much, much higher, but of course most PE funds have 10 or more companies in the portfolio.  I suspect we could find some historical return data that would help here.  Unfortunately, academics are at a distinct comparative disadvantage here, as the best data sources are proprietary and expensive. 

I'm also not sure what the Black-Scholes model gets you here, i.e., why it's better to use option methodology rather than just looking at historical returns for the sector as a whole. 

Knoll also discusses some possible re-structuring of the carried interest that might take place, and how that might affect revenue.  He notes, for example, that incentive fees might be paid by portfolio companies instead of the funds themselves, which -- if the portfolio company has a high effective tax rate -- generates a valuable tax deduction.  On the other hand, this changes the economics of the deal in ways that the LPs might not like (by measuring carry on a company-by-company basis rather than an aggregate basis), and it's not clear how many portfolio companies have a high effective tax rate.  (Recall that most portfolio companies take on a lot of debt in connection with the buyout.) 

It will be interesting to compare Knoll's paper with government's revenue estimate and methodology. 

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The Senate Finance Committee held another hearing on Carried Interest today; you can read the written testimony here. 

While the political issue is very much up in the air in DC, even among some Democrats, it's safe to say that there is an academic consensus among tax profs on the issue:  the status quo is problematic, and it should be addressed.   Three academics testified to that effect today - Joe Bankman (Stanford), Charles Kingson (Penn), and Darryl Jones (Stetson).  I'd previously testified at a committee roundtable, and Mark Gergen (Texas) testified at an earlier hearing.

We may not all agree on exactly what to do about the tax issue -- (1) tax the grant of a profits interest at ordinary income rates, (2) tax the returns at ordinary income rates at the back end, or (3) a hybrid approach (like my Cost of Capital or loan approach), or (4) even repealing the capital gains preference altogether.  Some of us would apply the changes to all partnerships, others would limit it to smaller partnerships.  But as more tax academics weigh in, it's clear that there's a consensus that this is an issue worthy of legislative action.  There's myself, Mark Gergen (Texas), Joe Bankman (Stanford), Dan Shaviro (NYU), Lily Batchelder (NYU), Noel Cunningham (NYU), Darryl Jones (Stetson), Alan Auerbach (Berkeley), Chris Sanchirico (Penn), and many others -- everyone agrees that there's a case for reform.  And this isn't a bunch of lightweights; nor is it a group that generally believes in higher taxes, or more redistribution. We tend to believe in a broader base and lower rates, and that's one way of viewing carried interest reform.  There are really few academic voices in dissent; the most prominent voice in dissent had his research sponsored by the Private Equity Council, so I'm not sure he counts on this issue.

What's remarkable about all this is that we tax profs are not a group that agrees on much -- there's division in the tax academy about income tax vs. consumption tax, corporate tax vs. full integration, territorial vs. worldwide taxation, whether to have an estate tax. 

One way to see why a consensus has emerged on this issue is to consider what happens to carried interest in a consumption tax world.  Consumption tax advocates tend to believe that not taxing capital income is the best way to grow the economy, as it encourages saving over consumption.  Now imagine a capital gains rate of zero, i.e. no tax on investment income.  In that world, private equity fund managers would pay no tax at all on their carry, since it qualifies as investment income.  (The fund managers get to exchange services for an investment in their own fund using pre-tax dollars -- and pay no tax on the back end, either.)  That can't be the right result -- carried interest obviously represents a return on labor, not capital.  So even if you have an underlying belief that encouraging investment is the best system for economic growth, we need to deal with the carried interest issue.  And it's this kind of thinking that explains why, in addition to the likes of the New York Times and Washington Post, you also have the Economist and Financial Times in favor of carried interest reform.

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Wow, did I pick the wrong week to move.  Blackstone went public, KKR is rumored to do the same, the Baucus-Grassley PTP amendment gathered momentum, Blackstone may lose its 5 year transition relief, and then the big one -- on Friday some House Dems introduced a bill that would tax carried interest at ordinary income rates.  Busy week.  I discovered that it's awfully tough to find a public wifi connection in the middle of Missouri (I was hoping to read the text of the House bill before close of business Friday).  Highlight of the trip was talking to a British reporter about the Blackstone IPO from a McDonald's in Macon, Missouri.  I managed not to ask the cashier what her tax rate is, fearing it might be higher than the Blackstone guys. 

A few quick thoughts about Blackstone and the new bill.

1.  What Blackstone's "poplet" means.  Blackstone closed its first day of trading about 13% above its IPO sale price, a modest pop.  But this almost certainly would have been higher if the Baucus-Grassley amendment hadn't gathered momentum and House Dems hadn't introduced new legislation.  All things considered, a successful IPO, and a good day for Blackstone. 

2.  The Blackstone IPO is not the new Netscape IPO.  Some folks are comparing the Blackstone IPO to the Netscape IPO - an indication both of a new bubbly era on Wall Street (then, a dot com era, now, a private equity era) and a loss of investor rationality.  But I think the better comparison is to that of Goldman Sachs back in 1999.  Goldman Sachs had been a partnership for a long time, and it was surprising to see Goldman go public.  But GS has thrived since then.  Similarly, Blackstone is becoming a mature, diversified, financial services firm, and its IPO makes sense for a lot of reasons, including acquiring a base of permanent capital for growth and shares for acquisition currency, as well as providing some liquidity to the founders and managing directors.

3.  Taxes are a small issue.  Senator Baucus suggested this week that he's open to the idea of shortening the transition relief period for Blackstone (and Fortress and Oaktree).  And of course if the House Bill passes Blackstone would pay 35% on its carried interest allocations.  But Goldman Sachs has done just fine despite paying tax at a 35% corporate rate.  Blackstone will be okay too -- the tax hike just takes a little froth out of the cappuccino. The fact that Blackstone completed a successful IPO in the midst of all of this shows that the real forces driving private equity returns go way beyond tax. 

4.  The House Bill seems rushed.  I still need to sit down and read the legislative text carefully, so I'll save my nits for later in the week.  Naturally, I'm pleased that someone has introduced legislation on the broader taxation of carried interest issue, but I'd been hoping that it would emerge first as a bipartisan bill from Senate Finance before being formally introduced in the House.  I don't see this as a class warfare issue, and I hope it doesn't become that.  To be sure, in an era of rising inequality, watching the richest pay tax at 15% doesn't make much sense.  But the longer we can keep the focus on good tax policy, the better.

5.  "We Pay Less in Taxes Than Our Janitors."  To defuse the class warfare issue, PE fund managers need a soundbite that works -  the "private equity pays less tax than the cleaners" soundbite is killing PE in Britain, and it will really hurt them in the US too.  Just as the civil liberties crowd is always hurt by the "Constitution is Not a Suicide Pact" line, PE needs to find a soundbite that works, and fast.  Suggestions welcome in the comments.  Nominations include "Assault on the Investor Class" (WSJ op ed), and "This Year's Man Behind the Tree" (Holman Jenkins).  Anti-PE slogans are more fun, like  "You Don't Know What a Few Extra Decimal Places Taste Like" (Return of the Player, via Percy Walker), Subsidizing the Barbarians at the Gate, or And You Thought CEOs Were Rich.

Related Posts:

Pricing Blackstone's Tax Risk

Oaktree Capital: The Other PE PTP?
The Blackstone Amendment to the PTP Rules
The Blackstone IPO: Two and Twenty on Drugs
AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

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It's a taxation of carried interest fiesta at the WSJ today:

Editorial, The Blackstone Tax (calling Congress a bunch of communists)
Alan Murray, The Real Answer on the Blackstone Tax Rate (mentioning my cost-of-capital analysis)
Sarah Lueck & Brody Mullins, Rangel May Back Higher Levies on Buyout Firms (noting consideration of the Baucus-Grassley bill may happen as soon as July)
Peter Lattman, Academic Gets His Close-Up In Private Equity Tax Fracas (profiling me)
Peter Lattman, Law Blog (same)
Yvonne Ball, Blackstone IPO Expected to Make its Trading Debut on NYSE Friday (deal will be priced tomorrow night)

Curious how the tax issue will affect the pricing of the Blackstone IPO, which will be priced tomorrow.  Blackstone would get five years transition relief from the corporate tax under the Baucus-Grassley bill, which would dampen the effect of the change, plus it's hardly a sure thing that the bill will pass.  On the other hand, I've been hearing rumors that the Finance Committee is indeed considering a bigger bill on the taxation of carried interest (not just the PTP issue), which would moot the transition relief issue if passed.  But I should emphasize that I've heard this from reporters who are hearing this from lobbyists (not Senate aides) so who knows.  Across the pond, there's even more momentum for increasing the tax rate on carry. 

Related Posts:

Oaktree Capital: The Other PE PTP?
The Blackstone Amendment to the PTP Rules
The Blackstone IPO: Two and Twenty on Drugs
AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

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The Blackstone Amendment stirred a lot of press coverage (see Paul Caron for all the links); I'm quoted in the NYT and WSJ today.  

What about Oaktree?  Most of the attention has been on Fortress and Blackstone.  But I suspect the legislation also affects Oaktree Capital, an investment management company based in LA.  Oaktree has about $40B assets under management, about half the size of Blackstone.  In a recent deal that bears many similarities to Blackstone, Oaktree sold about 15% of itself to institutional investors in a quasi-public offering.  The twist is that only a limited number of accredited investors can buy the shares, and they can only trade their shares through a portal managed by Goldman Sachs called GSTrue (Goldman Sachs Tradable Unregistered Equity).  (See the WSJ stories here and here.)  The idea is to get (most of) the liquidity of the Blackstone structure without the hassle of securities regulation that weighs on public companies.  

Brother, can you spare an offering memo?  I'm working at a bit of an informational disadvantage here, since I don't have an offering memo.  So I don't know exactly how the Oaktree structure works, or, for that matter, how Goldman's portal works; rather, I'm guessing based on the information in news reports.  Such are the challenges of academic research on private equity.

The PTP Rules.  With that caveat, it's hard to see why Oaktree wouldn't be affected by the Blackstone Amendment.  The PTP (publicly-traded partnership) rules affect both (1) companies that trade on established securities markets and (2) those that are readily tradable on secondary markets.  Surely Goldman's GSTrUE market counts as a secondary market.  And I would imagine that Oaktree is relying on the "qualifying income" exception to the PTP rules.  The new legislation, introduced Thursday by the Senate Finance Committee, would prohibit firms like Oaktree from relying on that "qualifying income" exception, and as a result, one would expect Oaktree's quasi-public partnership to get pulled in to the world of corporate taxation by Blackstone's undertow. 

Like Fortress and Blackstone, Oaktree would get five years of transition relief.  Oaktree was rushing to beat Blackstone to market.  I'm sure they are glad they did.  Five years of avoiding corporate tax is better than none. 

The future of quasi-public entities.  None of this heralds the end of the blurred public/private entity distinction.  There are broader forces at work (see generally Ribstein, and this recent paper by Ron Gilson & Chuck Whitehead).  But the Baucus-Grassley bill does signal that tax policy will not remain neutral on this topic; if you want to access our public (or quasi-public) equity markets, you must pay the corporate tax.  In light of how the capital markets have developed, whether that tax policy is sustainable in the long run is debatable. This isn't to say that the Baucus-Grassley bill is a bad idea.  So long as we have a corporate tax, we might as well police the rules.  The Baucus-Grassley bill is a sensible first step on the way to re-examining the taxation of carry (i.e. labor income vs. capital income) and the normative justification for the corporate tax (i.e. corporate tax vs. partnership tax).  Those topics may take years to resolve. 

Comments are closed as Miranda and I pack up to join the Bloggiest Law School Ever.  I welcome comments (and offering memoranda) at victor.fleischer (at) gmail.com.

Related Posts:

The Blackstone Amendment to the PTP Rules
The Blackstone IPO: Two and Twenty on Drugs
AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

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A bill by Baucus and Grassley was just announced.  See here.  It's a rifleshot approach that makes investment advisory and asset management firms ineligible for the 7704(c) "passive-type" income exception.  Blackstone, as a publicly-traded partnership, will be taxed as a corporation under the general rule of section 7704.

Interestingly, as I read the statute, Fortress and Blackstone would receive five years of transition relief, with the amendment not kicking in until 2012.  The legislation shouldn't affect the pricing of the Blackstone IPO too severely, then, although the additional 35% tax at the entity-level will still bite a little, even discounting it five years out. 

Of course, if Congress changes the tax rules relating to carried interest before 2012, the transition relief becomes less helpful. 

This is all pretty sensible.  Congress will close the PTP loophole using a very narrow fix, and will continue to consider the taxation of carry, but without completely blowing up the Blackstone deal in the meantime over a tax issue. 

(N.B. Because the amendment targets investment advisory and asset management firms, oil and gas partnerships - the main users of PTPs, are not affected.  Which sort of begs the question why oil and gas firms should get the benefit of avoiding the corporate tax while financial services firms have to pay up.  But I can see why the Finance Committee doesn't want to open up that particular can of worms.)

Previous posts on Blackstone:

The Blackstone IPO: Two and Twenty on Drugs

AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

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Congress is considering closing the loophole that allows Blackstone to go public as a publicly-traded partnership without being taxed as a corporation.  What makes the deal so interesting is that the issues go beyond entity classification into the nature of Blackstone's income. 

I presented an early draft of my Blackstone paper at the Junior Tax Scholars Conference last weekend and received some really useful comments from Adam Rosenzweig and Alex Raskolnikov.  I won't have a chance to post the paper before the IPO closes (rumored to be the week of June 25), so I thought I'd record my thoughts in case there are any investors out there trying to assess the tax risk on the deal. 

As I discussed in grueling detail in previous posts, Blackstone squeezes itself into the "passive-type income" exception to Section 7704, which normally treats publicly-traded partnerships as corporations.  Because Blackstone earns most of its income in the form of carried interest distributions, which give rise to capital gains, and because capital gains are listed as passive income under the statute, it can fit into the passive income exception.  Active income like management fees, deal monitoring fees, breakup fees and so on are passed through a blocker entity that "cleanses" the bad income by paying a corporate level tax on that income and distributing the after-tax income up to the public partnership in the form of a dividend.  Blackstone gets two big tax breaks, then: (1) the capital gains preference on carry and (2) avoiding an entity-level tax.

Congress may simply close the loophole by repealing the passive-type income exception from section 7704.  To my knowledge, other than a few oil and gas partnerships, few investment vehicles use the exception, so little is lost by repealing it. 

It's worth noting, though, that the heart of the problem in the Blackstone deal is the tax code's treatment of carried interest distributions as capital gains rather than ordinary income.  If carry were properly treated as ordinary income, then Blackstone would have to run the income through the blocker entity and pay a corporate tax anyway.  But if carry is treated as capital gain, then it can be passed directly up to investors, who benefit from the capital gains preference. 

The Blackstone deal underscores the fallacy of treating carried interest distributions as passive income.  The deal is, as one of my discussants noted, "Two and Twenty on Drugs."  What he meant by that was that the Blackstone IPO structure takes the tax advantage of carried interest's treatment as capital gains and leverages that tax treatment into a vehicle for going public without paying an entity-level tax.  Fix the tax treatment of carry, and the Blackstone deal structure falls apart. 

Previous posts on Blackstone:

AFL-CIO vs. Blackstone
Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

Update:  A helpful reader points out that there are more than "a few" existing PTPs.  See here.  By my count, still fewer than 100, mostly natural resources.  An handful of real estate partnerships, and of course, Fortress (the first private equity/hedge fund management company to go public using this structure).  These firms are enough to form a lobbying crew, but it's hardly a huge sector.

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I've posted a revised version of my Two and Twenty paper on SSRN.  The new version should be available on SSRN shortly; in the meantime, any interested readers can email me for a copy. 

I've added a policy recommendation at the end of my menu of reform alternatives.  Congress should adopt a baseline rule treating carried interest distributions as ordinary income.  Allocations of income that are disproportionate to the amount of capital a partner has invested in the fund should be treated as ordinary, regardless of the character of the income at the partnership level. 

Treating carry as ordinary income would protect our progressive tax rate system, which is consistent with widely-held principles of distributive justice.  Moreover, by treating carry more consistently with other forms of compensation, the rule would discourage wasteful tax planning activities, like the varied ways in which fund managers convert management fees into special priority allocations of carry. 

The Cost of Capital Method.  As I explain in the paper, there would still be a planning opportunity that would allow fund managers to structure around the new rules and achieve a mix of ordinary income and capital gains.  Specifically, fund managers could restructure the carry as a nonrecourse loan from investors.  From a policy standpoint, however, this result is acceptable.  Under tax rules that are already in place, fund managers would recognize ordinary income on the portion of their compensation that represents a return on human capital and would receive capital gain (or loss) only on the portion of their compensation that reflects true entrepreneurial risk.  The net result is equivalent to my "Cost of Capital" method, but imposed by private ordering into existing tax rules rather than by legislative fiat.

At the end of the day, then, we would have a simple baseline rule.  Carry is treated as ordinary income.  If fund managers want to go to the trouble of restructuring the carry as a non-recourse loan, existing rules dealing with interest (or forgiven interest payments) on that loan bring us to an appropriate tax result. 

Comments welcome off-line at victor.fleischer (at) gmail.com.

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Kara Scannell and Sarah Lueck at the WSJ report Senator Levin's desire to close the book-tax gap with respect to stock option expensing.  For a long time, companies reported no compensation expense for financial accounting purposes.  Financial accounting rules now require companies to estimate the value of options at the time of grant and report that amount as a compensation expense, which reduces reported earnings.  The tax treatment of options, however, has remained the same all along.  Companies take no deduction at the time of grant.  Instead, they wait until those options are exercised, and then take a deduction for the difference between the market value of the stock and the strike price.  If the stock price appreciates and the options become valuable, then this results in a larger deduction. 

Some folks have started to wonder ... if we can value options at the time of grant for financial accounting purposes, then why not for tax purposes?  Should we allow companies to report low option values (at the time of grant) for financial accounting purposes, but high value (at the time of exercise) for tax purposes?

Book-tax conformity is an appealing concept.  But the devil is in the details.

Revenue.  First, it's worth noting that this may not be as big a revenue-raiser as Senator Levin thinks.  Under current law, options which go unexercised generate no tax deduction for the employer.  Some options never vest (employees sometimes get fired or leave the company), and not every company's stock appreciates.  If we allow a deduction at the time of grant, companies would get a deduction for the option value up front, even though some options will turn out to be worthless. 

Pigouvian Tax on Accounting Gamesmanship.  Of course, if we do get book-tax conformity, and managers care more about the earnings reported to shareholders than they do about the earnings reported to the IRS (and there's considerable evidence that this is the case) ... then managers may understate the value of the options for both book and tax purposes.  This is a nice example of reverse regulatory engineering -- the government using financial accounting incentives to restrain tax gamesmanship (and vice versa). 

Put another way, it's like a Pigouvian tax on accounting gamesmanship.  In the same way that a carbon tax would reduce unwanted carbon emissions, book-tax conformity would reduce unwanted inflated  reported earnings to shareholders.  What's dangerous, though, is that it could lead to depressed reported earnings, which can create its own problems in the capital markets.  For this to work, Congress might want to limit any proposed change to publicly-traded companies. 

Section 83 and the Matching Principle.  Second, book-tax conformity at the corporate level might conflict with the general matching principle of section 83 of the code.  Under section 83, employer deductions and employee inclusions are supposed to happen at the same time.  We don't worry so much about income deferral for employees because employers have to wait to take a deduction.

But if we accelerate the employer deduction, following the matching principle here would require that employees include the value of unvested options as income at the time of grant.  That would be quite a departure from our realization-based tax system.  This problem is conceptually identical to the problem of how to tax a profits interest in a partnership.  We know that the property is valuable to the employee at the time of grant, but its value depends on the performance of services that the employee has yet to perform.  Taxing unvested options would be similar to an endowment tax -- a tax on unrealized human capital -- rather than an income tax.   Taxing the employee up front also creates a liquidity problem.

So we'd probably have to de-couple the employer's deduction (which would occur at the time of grant) from the employee's inclusion (which would occur at the time of exercise).  Another possibility, I suppose, would be to apply my "cost-of-capital" method and impute an annual interest charge to the employee, reflecting the leverage embedded in an option.  This hardly seems worth the complexity, though.

De-coupling the timing of the employer deduction and the employee inclusion seems dangerous; tax lawyers are awfully good at exploiting these gaps.  Thinly-traded companies that don't care much about reported earnings could report high option values, generating large tax deductions. 

Summary.  In sum, we should generally strive to have both the accounting treatment of a transaction and the tax treatment of a transaction track the economics of a transaction as closely as possible.  In this case, though, it may not be possible for the tax law to get all the way there.  Stock options may be the unusual case where a book-tax gap is hard to avoid.  I'm willing to be persuaded, though, if someone can work out the mechanics in a way that makes sense. 

I'll try to work this into my "Sweat Equity" research project this summer. 

Recommended Reading:

Mihir Desai & Dhammika Dharmapala, Taxation and Corporate Governance: An Economic Approach (Summarizing the "agency cost" view of tax and corporate governance; this literature shows that tax gamesmanship and accounting gamesmanship tend to accompany one another.  Book-tax conformity, while increasing tax payments, may actually help shareholders as well by reducing managerial opportunism)

David Walker, Financial Accounting and Corporate Behavior

Victor Fleischer, Options Backdating, Tax Shelters & Corporate Culture

Link to Today's Committee Hearing

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I'm tentatively scheduled to appear on CNBC's "Closing Bell" tomorrow, May 17th, at about 4 pm Eastern time.  I'll be talking about (what else) the taxation of private equity funds.   

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